Real Options and Mergers - PowerPoint PPT Presentation

Real Options and Mergers . P.V. Viswanath. Class Notes for FIN 648: Mergers and Acquisitions. Stock Options. A call option on a stock is the right to buy a share of stock at a pre-specified price (exercise price) within a specified time period (time to maturity).

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A call option on a stock is the right to buy a share of stock at a pre-specified price (exercise price) within a specified time period (time to maturity).

Thus, a call on Sprint with an exercise price of $22.50 and an expiration date of May 19, 2006 traded at a price of $2.15 at close on Feb. 22, 2006.

The closing price of the stock on that day was $23.80, so if the call had been exercised right away, it would have resulted in a loss. Still the option has value because the stock price might well go up before May 19, 2006.

A real option is similar to a stock option. The primary difference is that the real option is not traded on a market and, often,

The underlying asset may not be traded on a market, either.

Thus, a patent grants the owner an option because s/he has the sole right for a certain amount of time (time to maturity) to develop a product based on the patented idea by investing the necessary capital (exercise price).

The patent may or may not be traded;

The underlying asset in this case, is the product based on the patent. In this case, the underlying asset is not traded, either.

Right to start up a business under an exclusive fast-food franchise that you purchased, that expires within three years unless you own one or more outlets and that requires further spending to exercise. You are the exclusive franchisee in your territory. Whether and where you exercise the right is contingent on the results of a market survey, on zoning rulings by government, and on actions by competitors.

Opportunity to open a restaurant in your community under a generic name, “Downtown Grille.” You didn’t pay to acquire this opportunity. There is not much uncertainty: you can rent the perfect location that will deliver a steady clientele. It looks like a good deal already.

You must decide whether to invest now in new manufacturing capacity, for an outlay of $20 million, or wait a year. If you delay, you must engage a contract manufacturer that will cost your firm $1m. More to produce goods than if they were produced at the new plant. Demand for the product is uncertain. There is a 50-50 chance of the demand generating a new business with either a present value of $100 million or a present value of zero. If you delay, the new plant will cost $25m. next year.

What is the value of the call that EM.TV got, and what is the value of the put that EM.TV gave?

We don't really have enough information here to estimate these values precisely since along with the actual transfers of money and options, there is also updating by the market on the value of the other assets that EM.TV has

However, we can evaluate certain hypotheses -- for example, did the change in value reflect on the value of the options or was there an information component, as well?

The two sides negotiated a price support agreement that protected Apache on the downside in return for guaranteeing Amoco a portion of the upside.

Under the terms of this agreement, Apache would receive support payments if oil prices fell below specified reference prices for any year during the two-year period ended June 30, 1993, and Amoco would receive payments if oil prices rose above specified reference prices for any year during the eight-year period ending June 30, 1999, or in the event gas prices exceeded specified reference prices for any year during the five-year period ending June 30, 1996.

Oil price sharing payments due Amoco for contract years ending 6/30/1994 to 6/30/1999, would be based on per barrel oil prices starting at $24.75 and increasing to $33.13.

Annual oil volumes would decline from approx 3.3 million barrels to 1.4 million barrels over the remaining term.

Gas price sharing payments would be based on gas volumes starting from approximately 13.4 Bcf for the year ending 6/30/1994, and declining to 10.5 Bcf in 1996.

The referenced gas price would increase from $2.18 per Mcf in 1994 to $2.68 per Mcf in the final year.

If price sharing payments are due to Amoco, the volumes listed above would be doubled until Amoco recovers its net payments to Apache ($5.8 million through the contract year ended June 30, 1993) plus interest.

Apache, which believes that oil prices are not likely to increase will arrive at a lower estimate of the PV of the payments to be made to Amoco; and at a higher estimate of the PV of the payments that Amoco has to pay to Apache.

Amoco’s estimates are the opposite.

Hence, the price sharing agreements constitute a price reduction for Apache and a price increase for Amoco.